A guarantee is basically a promise to satisfy the performance of an agreement. A guaranty is similar, but is used to satisfy the performance of a loan by an individual. Analysis of credit and guaranties is a discipline that only the most qualified people should perform. Investigating guaranties is never performed alone -it is part of the overall credit review of a business requesting a loan. It is a complex set of procedures beyond the scope of this article. This article will summarize the elements involved to investigate a business loan guaranty. Consult with your CPA or Banker for assistance before attempting to do it yourself.
Investigating a personal guaranty for business loans is part of commercial credit analysis. The credit-underwriting department of a commercial bank or business lending institution typically performs this analysis. Any institution or person considering the extension of credit related to a business can perform credit examination. All guarantors must complete a Personal Financial Statement accompanied by tax returns and sometimes-additional supporting financial statements. Guaranties are legal agreements that obligate a third party, usually a business owner or key corporate officer, to repay a business debt should the business entity default on its repayment of a credit facility. A guaranty is not a primary source or substitute of a borrower’s credit worthiness.
Personal guarantees are frequently obtained from the owners of a corporation, partnership or any other form of a business entity. From the lender’s perspective, a personal guaranty ensures the personal and business interests of the owners are equivalent. If the business entity defaults on the loan, the guarantor promises to cure the default. Since most guaranties are unsecured, their values are more psychological than tangible. However, a lender can ask for some type of personal collateral of the owner for additional security for the making the loan. For example, the lender may ask for a pledge of a secondary lien on the owner’s home. The type of property pledged depends on the risk factors calculated by the lender. Some property holds greater security values than others.
Investigating the credit worthiness of a loan and a guarantor involves careful credit investigation. In commercial lending, banks will apply principles called the 5 Cs as a basis for credit examination. The 5 Cs are Character, Capacity, Capital, Conditions, and Collateral.
Character – This relates to the motivation of the borrower to repay a debt obligation. It is unlike any other financial performance indicator found in the financial statements. Determining character is a judgment call derived from careful interviewing of the applicant and study of the applicants’ historical credit reputation. Background checks and interviews with others having business relations with the applicant are useful to make a fair appraisal.
Capacity – “Cash is King”. Loans are repaid from cash generated by the business’ operating cycle. Can the borrower manage their cash efficiently enough not only to repay the loan, but all other debts simultaneously? Historical financial performance is evaluated to determine how the borrower handles their debts and expenses. Sources to review include the Income Statement, Statement of Cash Flows, and partially the Balance Sheet. A new or very young business is difficult to judge because they have not yet accumulated enough historical data to review.
Capital – It is the funds available to operate a business. The two primary conditions in this area involve the amount of owner’s equity (OE) and efficient uses of the capital to operate the business. It is not good when borrowed capital (credit) is greater than OE. Careful scrutiny of the Balance Sheet is required in this area. The purpose of capital is to maintain operations. Borrowing funds to augment operations is normal. However, too much borrowed capital is a sign that something is wrong.
Conditions – These are external factors relative to the industry of the business. The current state of the economy is a good example. Industry events and situations (current and predicted) are taken into consideration as to how it affects the business. For example, if a key supplier of the business experiences a labor strike, further investigation is needed to consider the affect on the business. Interviews with key officers and the business owner can shed light on what is happening. Additional resources like trade journals, industry news reports and the like are useful tools.
Collateral – Lenders want repayment from cash, not property. The last thing a lender wants to do in a default is take the property pledged backing up a loan. Property pledged is only a means to offset weaknesses in the other Cs. It is a safety net of last resort should a loan default a secondary source of repayment. A collateral pledge is completely irrelevant if the loan request contains too many negative signs in the foregoing credit assessment areas.
Guaranties are generally classified as unlimited and limited. An unlimited guaranty covers all the debt obtained by a single borrower to a single lender. Limited guaranties are associated linked to a specific loan with a capped dollar amount.
Other types of guaranties include corporate and government agencies.
Corporate guaranties are similar to personal types except it is generally one corporation guarantying the debt of another corporation. Usually, large corporations guaranty the debts of its smaller subsidiaries or new business units.
Government guaranties are special situations, whereby a state or federal agency guarantees a business loan. An example agency is the Small Business Administration (SBA). Governmental guaranteed loans are very complex and typically take longer to process. A lender processing governmental secured loans must adhere strictly to the guidelines of the agency guaranteeing the credit. Under an SBA loan, the lender provides the money to the borrower and the SBA guarantees the loan amount up to certain percentages depending on the program loan used. Each loan program has specific qualifications and conditions attached to it. Anyone can contact the SBA directly for more information by visiting www.sba.gov. It is recommended to speak with an SBA approved lender to see what options are available. Obtaining an SBA loan is often the best choice for a business because the borrower cannot qualify under conventional terms. The SBA assumes most of the risk, thus making the credit request more palatable for the bank.
Careful credit examination is required to investigate any guaranty for business loans. Analysis should account for all tangible and intangible factors of the individual guarantor with the associated business. The guaranty does not stand alone without review of the business. Credit analysis is both an art and a science. Sound judgment based on financial data, combined with practical experience is necessary to consider all variables of a credit request. Professionals that have formal credit training usually perform business loan analyses. Consult with your CPA or Banker for assistance before attempting to do it yourself.